8
AMERICAN INSTITUTE OF CERTIFIED PUBLIC ACCOUNTANTS
1996 Twenty-Fourth Annual National Conference on
Current SEC Developments
Washington, DC
December 10, 1996
DANGEROUS IDEAS
Remarks by
Michael H. Sutton
Chief Accountant
Office of the Chief Accountant
United States Securities and Exchange Commission
Washington, DC
__________________________________
The Securities and Exchange Commission, as a matter of policy,
disclaims responsibility for any private publication or statement
by any of its employees. The views expressed herein are those of
Mr. Sutton and do not necessarily reflect the views of the
Commission or the other members of the staff of the Commission.
“Dangerous Ideas”
Introduction
Good morning. It is a pleasure to be here with you again
and to share some thoughts on accounting and financial
reporting.
Like most of you, I spent the Thanksgiving holidays with
family, and to my good fortune, that included grandchildren.
Having small children in our home again reminded us of the
dangers all around when toddlers are on the scene. A living
room that is perfectly safe in the hands of adults becomes a
minefield of sharp-edged coffee tables, naked electric
sockets, and windows and doors that open to unexpected
perils. Certainly, some of our concern for safety reflects
the natural anxiety of grandparents, but some of it is based
on the knowledge and experience of past mishaps.
When I returned to the office and again took up some of the
difficult accounting issues we encounter, it occurred to me
that in financial reporting we often encounter ideas -- or
proposals -- that to many seem safe in normal day-to-day
practice but that, on closer inspection, can pose perils to
the credibility of financial reporting and to the interests
of investors. In accounting, as in life, what can seem
harmless in some circumstances can become hazardous in
others.
What I plan to do this morning is to explore a few of these
“dangerous ideas” as they apply to the world of accounting.
Those ideas are as follows:
· The matching principle should shape the financial
statements.
· Intangible assets have indefinite lives.
· Good disclosure can cure bad accounting.
· Accounting drives business decisions.
· Auditors have closed the expectation gap.
Matching and Loss Deferrals
One of the most common ideas that we encounter is that the
matching principle should take precedence in shaping the
financial statements. A corollary idea, and one also
frequently advanced, is that current period losses can
create assets.
At first blush, those ideas can be understood. After all,
why would a company incur a cost if a future benefit is not
expected? A closer look, however, reveals that both of
those notions, when and if implemented, have the potential
to undermine the integrity of the balance sheet and,
therefore, the credibility of a company’s financial
reporting. It is hard for investors to understand why
things like deferred advertising costs or customer
acquisition costs or start-up costs represent assets. When
a registrant adopts an accounting policy -- based on
matching theory -- that results in the deferral of costs
normally associated with ongoing operations, concerns about
the quality of the asset created and, therefore, the quality
of earnings follow.
To appreciate some of the pitfalls associated with matching,
let’s look for a minute at an industry where there are
specialized accounting practices that rely heavily on that
theory -- the public utility industry.
Under Financial Accounting Standards Board Statement 71,
which addresses the accounting for rate-regulated
industries, many costs that would be expensed by non-
regulated enterprises are capitalized and carried as
“regulatory assets”. This practice -- described as
reflecting “the economic effects of the rate-making process”
1-- is an elevation of the matching principle to recognize a
specific circumstance in which current period costs can be
attributed to future revenues and existing legislation
provides a strong expectation of recovery of those costs.
It is rare for a company other than a rate-regulated
enterprise to have a similar level of assurance about
recoverability of current period costs. Indeed, recent
trends toward deregulation in the utility industry raise
questions about whether companies that are currently rate
regulated will be able to recover deferred costs that have
long projected recovery periods. But outside of rate-
regulated industries, there usually is no direct and
traceable linkage between current period expenses and a
specific future period revenue, even though it may be
possible to associate, at least in part, current period
activities with future revenues.
Taking the “high road” and recognizing operating costs in
income as they are incurred may be painful at first -- like
starting a long run at the bottom of a hill -- but companies
that select accounting policies that postpone recognizing
expenses often lose credibility in their financial
reporting. They frequently come under pressure to change
and find that explaining why the new policy is preferable --
but that the old policy was acceptable too -- is a difficult
task that can strain investor confidence. The reality of
this credibility issue was illustrated recently when an
analyst, describing a massive write-off of marketing
expenses, commented, “The earnings numbers were meaningless
-- they were a house of cards.”2
As basic as the deferred cost issue is, it is one that comes
up often, and I encourage all of us to look with skepticism
at proposals that elevate the matching idea to the point
that it overrides the definition of an asset.
Intangible Assets
Let me turn to the suggestion that intangible assets have
indefinite lives.
As many of you know, the current International Accounting
Standard for business combinations requires goodwill to be
amortized over not more than 20 years.3 The International
Accounting Standards Committee is now revisiting that
standard as part of its core accounting standards project,
and the debate has been contentious. In its deliberations,
the IASC has moved away from the 20-year maximum life and
has taken an approach that would establish no upper limit on
the amortization period for intangible assets that are
perceived to have indefinite useful lives. Instead, an
ongoing impairment test would be required. The effect of
such a standard would be to permit companies to not amortize
some intangible assets.
In my view, amortization is a necessary consequence of the
decision to recognize intangibles as long-lived assets.
Under our current accounting model, the initial cost of long-
lived assets is allocated -- amortized -- over the estimated
useful lives of those assets. That principle should be
applied to intangible as well as tangible assets.
Likewise, it seems that there should be some reasonable
limit on the allocation period. Even assets that remain in
use for many years -- even the most valuable brand names --
require significant ongoing support to maintain their value,
and the distinction between value acquired and value created
by subsequent ongoing maintenance blurs quickly. I doubt,
for example, that it would be feasible to separate the value
-- and the additional life -- created by current
expenditures for advertising and other marketing activities
from the value originally acquired when trying to decide
whether the original cost of a brand name has been impaired.
In recent times, we have seen a number of sudden and major
goodwill write-offs, and those events have led to questions
about the reliability of impairment accounting. In number
of cases, despite assigned lives of 25 to 40 years -- the
periods over which companies expected to receive superior
returns from premium investments -- all of the goodwill was
reported to be impaired and written off in a single quarter.
The staff’s experiences have led me to question whether an
impairment standard could be developed that would be an
adequate substitute for systematic amortization.
As you may recall, the “indefinite useful life with an
impairment test” approach was the accounting model that
preceded APB Opinion 16, and it didn’t work very well. The
40-year maximum amortization period required by Opinion 16
was established to assure that the cost of intangible assets
would not be spread over extremely long periods, and
practice has shown that even a 40-year limit may be too
long.
Certainly, this is not a new problem, and finding answers
will not be easy. Still, I think we have to be careful to
avoid repeating old mistakes.
Disclosure vs. Accounting
Another idea that can be hazardous to sound financial
reporting is the suggestion that disclosure can cure bad
accounting.
Without question, good disclosure is an essential component
of effective financial reporting. It’s the flesh on the
bones of the balance sheet and income statement; its the
words that make the numbers in the financial statements
become three dimensional. But disclosures are, in point of
fact, the modifiers of the accounting. Good disclosure
doesn’t cure bad accounting any more than an adjective or
adverb can be used without -- or in place of -- a noun or a
verb.
In Accounting Series Release 4,4 the Commission recognized
the importance of this issue when it concluded that no
amount of supplemental disclosure can justify the use of
unacceptable accounting principles. Thus, for example, cash
basis accounting for cost of goods sold would be viewed as
misleading, even if accrual basis amounts were disclosed
fully in the footnotes.
While using cash basis accounting for cost of goods sold may
be an extreme example, there have been a number of cases in
which footnote disclosure has been urged as a remedy for
something close to cash basis accounting. Remember, for
example, that when the FASB proposed using accrual
accounting for postretirement benefits, some urged that the
pay-as-you-go approach be maintained and that footnote
disclosures be improved. You will recall that in Statement
106, the Board concluded that disclosure is no substitute
for recognition and that “the usefulness and integrity of
financial statements are impaired by each omission of an
element that qualifies for recognition.”5 I believe that,
with hindsight, almost everyone now agrees with the Board’s
decision in that project, and equally interesting, many
managers have recognized that the information they obtained
about their long-term obligations was of significant value
in managing their businesses.
Similarly, in Statement 12, the Board prescribed footnote
disclosure of the market values of investments in marketable
debt securities as a supplement to accounting based on
amortized cost.6 Because of continuing concerns about the
accounting for those instruments, the Board concluded in
Statement 115 that the recognition of market values resulted
in more relevant financial statements.
Today, this same issue has been raised in the context of the
Board’s derivatives and hedging project. Some have
suggested that good disclosure, such as the quantitative
disclosures in the Commission’s market risks disclosure
proposal, would avoid the need to record and measure those
instruments in the basic financial statements.
Certainly, enhanced quantitative disclosures about market
risk will provide important information for financial
statement users. But those disclosures have different
objectives than the Board’s project to improve the
accounting for derivatives. I continue to believe that both
improved accounting and improved disclosures are needed, and
I encourage the Board to complete its deliberations as soon
as practicable.
Accounting and Business Decisions
We often hear that business decisions are driven by
accounting. This idea takes a variety of forms, including
suggestions that, if a particular accounting treatment is
not allowed, it will be impossible to consummate a
particular transaction.
Trying to develop accounting rules based on a prediction
about how business decisions might be made may be the
financial reporting equivalent of “the tail wagging the
dog.” While, as accountants, we should be proud of the
important role financial reporting plays in business and in
our capital markets, we should remember that accounting is
and should be a vehicle for effective communication.
Accounting should report the facts in the most relevant and
reliable way possible, and it should be unbiased.
As an example, when the staff is engaged in discussions
about the applicability of pooling of interests accounting
or other forms of carry-over basis accounting, we often hear
that the preferred accounting is critical to the
marketability of the stock being sold and, thus, accepting
that accounting would encourage capital formation. One
submission pleaded that we should “rise above the technical
merits” of the accounting analysis and not object to pooling
of interests accounting so that the company’s shareholders
could realize increased share values.
Those arguments, however, have another side. What may be
good for selling shareholders in a particular circumstance
may not be good for the buying shareholders -- the new
investors and shareholders on the other side of the
transaction. In other words, a good price for the seller
may be a bad price for a buyer.
Each day, we, like you, encounter other requests to accept
or encourage an accounting treatment that will not deter
some form of business or capital market activity that is
believed to be highly desirable. We should all see “red
flags” flying when we are told that the accounting will make
or break a deal -- or create or destroy a particular market.
While accounting can be an important factor in some
circumstances, we all should recognize that accounting that
masks, or fails to capture, meaningful information for the
benefit of all investors is not sound. We should all share
the goal of enhancing the ability of accounting to express
the story of an enterprise’s financial performance in a
meaningful, accurate and consistent way.
The “Expectation Gap”
I will close with a periodically recurring idea -- a hopeful
suggestion -- that, finally, auditors have closed the
“expectation gap”.
The term “expectation gap”, of course, was coined to
characterize the difference -- sometimes very significant --
between what the “ordinary person” was thought to perceive
an auditor’s role to be and the responsibilities that the
profession established for itself. The bigger the
difference, the wider the “expectation gap”. Auditors have
spent years trying to narrow that gap.
The most recent effort is a new auditing standard that
specifically requires auditors to assess the risk of
material misstatements in financial statements as the result
of fraud. This new standard, for the first time, refers to
fraud by name instead of by the more euphemistic term
“irregularities” and describes over 40 fraud risk factors
that the auditor is to consider in planning and performing
the audit.
Based on our discussions with representatives of the
Auditing Standards Board and others, the new standard is
expected to improve auditor performance by causing auditors
to spend more time looking for and analyzing evidence of
fraud as well as providing better documentation of that
process. Auditing procedures are expected to be more
detailed and deliberate, and auditors are expected to
conduct more training for their personnel on how to search
for and respond to indications of fraudulent financial
reporting. In short, with the adoption of this standard, an
auditor should not be able to skip lightly over the issue or
to assert that it is not the objective of the audit to
discover fraud that is material to the financial statements.
But the new fraud standard can’t be expected to completely
close the “expectation gap”. In some respects, the
expectation gap is like an earthen dam -- it requires
constant maintenance. As soon as you plug one hole, another
seems to spring up. An expectation that has received
considerable attention recently has to do with the auditor’s
role in helping the board of directors assess the quality of
a company’s financial reporting.
One of the observations of the Public Oversight Board’s
Advisory Panel on Auditor Independence, which emphasized
this point, was that the board of directors “must expect,
and the auditor must deliver, candid communication about the
appropriateness, not just acceptability, of accounting
principles and estimates and the clarity of the related
disclosures....”7 As their report notes, current practice
appears to focus on whether an accounting principle is
“within the range of acceptable practice” rather than
whether it is the best practice for the specific
circumstances of the registrant. If this distance between
“within the range” and “best practice” is not scrutinized,
and if efforts are not made to reduce it, I fear that a new
gap will develop -- this time a credibility gap. If
companies select accounting policies that fall just within
the letter of the accounting law, we cannot be surprised
when financial reporting appears to fall short of investor
expectations.
The fact that there is a perceived need for auditor
communications with boards of directors about the quality of
reporting says a great deal about the complexities of
today’s accounting and auditing world, and it says a great
deal about the broadening of the corporate governance
process. But, investors depend on the expertise and
integrity of independent auditors to deal with those issues
every day -- and to call problems to the attention of those
responsible for policy and oversight. To continue to win
the war of the expectation gap, auditors need to speak up --
not just when things are wrong, but also when things aren’t
quite right -- to pose difficult questions about the quality
of reporting, and to seek full and fair disclosure.
Conclusion
I will conclude by saying that, sometimes, the biggest
challenge posed by “dangerous ideas” is recognizing them,
especially when they are presented in a familiar environment
and have seemingly worthwhile goals. I hope that, in the
next two days, the presentations by our staff -- which
inevitably focus on contentious and challenging issues --
will raise our level of awareness about those issues and
better prepare all of us for the challenges that lie ahead.
Thank you for your attention.
_______________________________
1 Financial Accounting Standards Board, “Statement of
Financial Accounting Standards No. 71, Accounting for the
Effects of Certain Types of Regulation,” 1982, Summary.
2 Sandberg, Jared, “America Online Plans $385 Million
Charge,” Wall Street Journal, October 30, 1996, page A3.
3 International Accounting Standards Committee,
“International Accounting Standards IAS 22 (revised 1993),
Business Combinations,” paragraph 42.
4 U.S. Securities and Exchange Commission, “Accounting
Series Release 4,” April 25, 1938. See Codification of
Financial Reporting Policies, Section 101.
5 Financial Accounting Standards Board, “Statement of
Financial Accounting Standards No. 106, Employers’
Accounting for Postretirement Benefits Other than
Pensions,” 1990, paragraph 164.
6 Financial Accounting Standards Board, “Statement of
Financial Accounting Standards No. 12, Accounting for
Certain Marketable Securities,” 1975, paragraph 12.
7 Advisory Panel on Auditor Independence of the Public
Oversight Board, “Strengthening the Professionalism of the
Independent Auditor,” 1994,
page 23.